Dividend Growth Model Formula

Dividend Growth Model Formula

Dividend growth model or formula is used to calculate the share value of the company. There are two famous formula used for calculating the share value. These formulas has been shown below

Dividend Growth Model- Zero Growth Formula

Share Price = Do                                Ke

AND

Dividend Growth Model- Zero Growth Formula

Share Price = Do ( 1+g)                                Ke-g

Do=Current Dividend

Ke =Cost of equity

g= Dividend Growth

 Dividend Growth Model Calculation

Dividend growth model calculation is based on the present value concept. Dividend Growth model is used to calculate the present value of future dividend. Dividend Growth model use the basic assumption of perpetuity (forever cash flows).

Significance of Dividend Growth Model

Dividend Growth model is widely used for share valuation and cost of equity calculation. Cost of equity is calculated by re arranging the above mentioned formula. Cost of equity calculation has been explained in my other article. There are two uses of dividend Growth model

1.    Cost of Equity

2.    Share Valuation

 Limitations of Dividend Growth Model Formula

Dividend growth model cannot be used in case of random growth and negative growth. Dividend growth can only be used in case of constant dividend (zero Growth) or a constant growth. Different Growths Types has been explained with examples in my other article of Historical dividend growth formula.

This model assume that dividend payment is regular activity (every year), but in fact dividend payment depends on number of factors, and company may not be in position to pay dividend every year. It is important to note that dividend payment is not obligatory requirement. The limitations of Dividend growth model has been explained below in more details;

1.    Limited Scope

Dividend Growth model cannot used for negative growth or zero growth situation. Thus dividend growth model has very limited scope.

2.    Dividend in not Obligatory

Dividend payment is not permanent or obligatory payment. Therefore using the assumption that dividend will always be paid is inappropriate. Dividend payment totally depends on the discretion on the management.

3.    No Relationship with Financial Performance

Dividend payment and financial performance has no direct relationship. Dividend payment does not reflect the good financial performance or position of the company. It is important to note that financial performance and financial position are two fundamental importance in share valuation.

4.    High Deceiving Dividend

Some companies may be paying high dividend to deceive the investors. The company management may be trying to manipulate the concept of dividend valuation model to attract new investor by paying high dividend. These tactics is widely used by the new listed companies.

5.    Accumulate Dividend

Some companies does not pay the dividend, rather invest fund for future growth of the company. Dividend growth model does not answer such situation.

Share Valuation Example (Zero) Growth)

Announced dividend (Current Year) = .9

Dividend Growth Expectation = No Growth

Cost of equity=13%

Solution

=.9/.13

=6.92

Share Valuation Example (Constant Growth)

Current year announced dividend = .9

Dividend Growth Expectation   =    5%

Cost of equity=13%

Solution

Share Price = Do ( 1+g)        

                       Ke-g

Do=Current Dividend

Ke =Cost of equity

g= Dividend Growth

Share Price = .9(1+5%)

                     13%-5%

Share Price = .9(1+05)

                       .08

Share Price = 11.8

Other name of Dividend Growth Model

Other name of dividend growth model is dividend discount model. These both terms and names can be used interchangeably.